Monday, May 16, 2005

The Second Easiest Trade in the World

The second easiest trade in the world might just be keeping a few investors around the world up at night.

I say second easiest, because there is one other macro trade that seems to be more popular than being short the U.S. Dollar. But if there ever was a way to make a guaranteed profit, it would appear to be shorting the Dollar.

After all, the U.S. is, as we all know—putting it in precise macroeconomic terms, based on our horrible trade deficit, bloated budget deficit, broken Social Security system, not to mention our decrepit Medicare/Medicaid/Health Care funding system—totally screwed.

And hasn’t the Oracle of Omaha—Warren Buffett—shorted twenty billion Dollars for his own account? Even Bill Gates, who probably never shorted anything in his life, except maybe Lotus and Netscape and Borland and Novell and Quarterdeck and Software Publishing and…well, he’s probably never shorted a currency before, but even Bill Gates is short the Dollar.

So, if Bill Gates and Warren Buffett—two of the smartest men in the world, let alone the smartest guys in a particular room—are both short the Dollar, how could a big, swinging London-based currency trader lose by putting on that trade?

Well, one way he could lose is this: what if everything the smartest guys in the world already know about the Dollar is priced into it? And what if the Euro—the alternative currency of choice—is overvalued? And what if that imbalance starts to correct itself?

I mean, it’s not as if Europe is rip-roaring along, adding value to the world’s economic well-being.

Germany is stuck in no-growth-land, Italy is officially in recession, and France is a basket case. Half a dozen U.S. companies have missed numbers in recent weeks, and blamed Europe. Drug companies are removing research and development from Germany, and IBM is shutting down high-cost operations all over the continent.

I’m no currency guru, and I don’t particularly admire the fiscal policies of the United States. But what’s so great about Europe? And why does everybody want to own its currency?

I know what some of you are thinking: buy gold. But I’m not a gold bug. My friends who actually are gold bugs tend to be nervous, excitable people who think Alan Greenspan ranks right up there with funeral directors and variable annuity salesmen.

They refer darkly to “The Powers That Be” and watch every tick in Federal money flows as proof of a vast conspiracy to manipulate the price of Amazon.com’s stock price in order to benefit Alan Greenspan’s personal account.

I’m not making that up, by the way—I know people who think Greenspan times his various pronouncements to affect the market, for his own benefit. Last year a guy complained Greenspan had made negative comments about the economy just before option-expiration Friday. He was long Lucent call options, and they expired worthless.

He blamed Alan Greenspan.

I don't particulary care who runs the Fed, and as far as I can tell gold and silver just sit there and impart no particular value except what other investors ascribe to the desirability of owning gold and silver at any given moment.

So call me an agnostic when it comes to the world’s monetary plight.

But I’d be willing to bet the ranks of the Dollar atheists far outweigh the Dollar believers right now. As I said, it’s probably been the second easiest trade in the world, up until now.

The easiest? Oh, that would be the “market-neutral” convertible arb trade. Which, as we now know, is blowing up all around us.

Just today, The Times of London is reporting some ugly data from the London hedge fund world:

GLG in recent weeks had demands for more than $500m (£270m) from investors wanting to pull out of its $4 billion market-neutral fund…Cheyne is thought to be down by at least 10% in its credit fund after the downgrading of debt at General Motors and Ford. Ferox, another of London’s most successful funds, is thought to be down nearly 20%. Bailey Coates, Polygon, Rubicon, Vega, Moore Capital and Brevan Howard are all nursing heavy losses of about 5% each in April.

Makes you wonder, if that stuff was the easiest trade in the world, how the second-easiest trade is going to work out.

Jeff MatthewsI Am Not Making This Up

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews' recommendations.

5 comments:

You make a bit of a leap saying the Euro is the alternate currency of choice and implying that's what Bill Gates and Buffett are in. I think anyone trading currency based on the long term fundamentals (which might be about 7 people!) would not be looking at the Euro to offset the USD. Euroland is in mucjavascript:void(0);publish this comment h worse shape than the US. The Aussie dollar is a good alternative as are CAD, singapore dollar, Remnimbi, Thai Bhat etc. A basket of Asian/oceanic currency has the benefit of the whole of low trade deficits as % GDP or surpluses along with budget surpluses. Short EUR long Asia/Commodity currencies is probably the smartes play right now (though without building some kind of model, I base that on empirical evidence - your note about efficient pricing in such large markets has to be close to correct).

Finally silver is worth looking at for a lot of reasons (almost none of which are shared with gold - it's easy to mention them together). Silver has been in a structural deficit for decades, it has real industrial uses that consume it, there is less silver left in the ground than any other commodity based on annual consumption and the talk of photography posing a problem on the demand side is a misdirection. Silver is selling for less than the cost of production (though take that for what it's worth) though some miners produce it as a by-product so it gets produced anyway. Anyway, once gold is mined it is rarely consumed, silver is consumed and has both precious metal and industrial uses....end lecture.

Of course i can wait for 2-5+ years for silver to play out but not everyone can!

the euro has been bid up because its the most liquid way to bet against the dollar. you can't use many of the asian currencies because their central banks intervene, whereas the ECB typically does not. as poor as the fundamentals look for the dollar, the euro is much much worse. in fact, the most logical, though most unlikely, move for the ECB is to cut rates, considering near zero growth and 10+% unemployment in the larger member states. with a rate cut out of the question due to politics, and a rate hike out of the question because of fundamentals, ECB monetary policy is "stuck". add to that the uncertainty surrounding EU member states voting to ratify the new constitution, where both France and the Netherlands appear poised to vote no, and the euro appears to be in for a difficult stretch. that said, a short term downward dollar correction is not out of the question now, as everyone has jumped on the greenback's bandwagon (see today's Wall Street Journal). I love how at $1.36/eur, everyone hates the dollar, but at $1.27/eur, people want to buy it. same old song, different asset class...

One other key factor in the currency equation is the relative use of leverage. Neither Buffet nor Gates strike me as the types to be leveraging their "bets" against the dollar to any significant degree - though who knows?

Also, to state that they are betting against the dollar is a bit misleading. Both Buffet and Gates still have more of their assets in dollar denominated assets - they are by no means net short the dollar. Isn't it prudent to be diversified by currency as well as asset classes etc..?

Finally, Doctor John Hussman of wwww.hussmanfunds.com has posted data on screens he has run showing that precious metal stock returns have been quite explosive in the past given the environment we are currently in - for example the Gold Bullion/XAU ratio being greater than 5x. With central bankers across the world cranking up the printing presses I think PM's are another important tool for diversification.

It is true that Buffett has plenty of Dollar-denominated assets, and a short-Dollar position might not be a bad way to hedge those assets.

However, Buffett does not think or act like most investors, who worry about diversification. He likes to make big bets when he thinks he sees something nobody else does, or, as he says, when he is the "only buyer."

In fact, Buffett abhors the notion of "diversification." He thinks it breeds mediocrity.

So I tend to see Buffett's Dollar short an investment position that he believes will make him a lot of money, regardless of what happens with the rest of his portfolio.

Most of Bill Gates' wealth is tied up in Microsoft, a company that does a lot of business overseas and would probably benefit greatly from a Dollar collapse, so I don't see Gates' bet being a hedging mechanism either.

But, I could be wrong.

As for gold being a good investment at discrete times in the cycle, and for various portfolio strategies, I won't disagree at all. It's just not my cup of tea.

I think putting a small % (10%) of one's portfolio in precious metals is prudent as there is the possibility that, in no particular order, the housing market crashes, FNM implodes, stock and bond markets crash, hyperinflation, USD loses its reserve currency status, foreign central banks diversify their holdings away from the USD, etc. Gold ends up being a good hedge for any USD depreciation due to any or all of these potential events. I wouldn't be surprised if gold goes to $1000/oz in a few years if we fall into a recession.Best regards.